Interdependence of the major sectors, markets and flows in a mixed economyD. Hompashe

Three major flows in the economy

An increase in the production of goods and services leads to an increase in income which in return increases spending.

• The determination of the total production of goods and services is an important issue in macroeconomics.

• We produce goods and services in order to consume those goods and services and thereby satisfy some of our needs and wants. The amount goods and services we can consume, depends on how much we can spend on these goods and services. The amount we can spend in return depends on our income, which is derived from taking part in the process of production. A continuous circular flow between production, income and spending takes place in the economy.

• Three important flows can therefore be distinguished in the economy. They are production, income and spending.

• By taking part in the process of production through selling factors of production an income is earned in the form of wages and salaries, rent, interest and profits. This income is then spent to buy the goods and services that were produced.

Circular flows

• Circular flow of goods and services • The households who are the owners of the factors of production offer their factors of production for sale on the factor market. Firms then purchase these factors of production and use them to produce consumer goods and services. These goods and services are then offered for sale on the goods market where they are purchased by the households.

• Circular flow of income and spending • The flow of income and spending is usually a monetary flow and its direction is opposite to the flow of goods and services.

• Firms purchase factors of production on the factor market from households. This spending by firms represents the income (wages, salaries, rent, interest and profit) of the households.

• The households, in turn, spend their income by purchasing goods and services in the goods market. The spending by households represents the income of the firms.

Circular flow with government

• The role of government in the circular flow of income and spending between firms and households can be illustrated as follows:

• Government purchases factors of production from households in the factor market, and goods and services from firms in the goods market. In return, government provides households and firms with public goods and services such as defense, law and order, education, health services and roads. These services are financed mainly through taxes on the income and expenditure of households and firms.

Circular flow with government

• Government spending, denoted by the symbol G, constitutes an injection into the flow of spending and income while taxes, denoted by the symbol T, constitute a leakage from the circular flow of income between households and firms.

Circular flow with foreign sector

• Circular flow of income and spending • Exports are spending that originates in the rest of the world. This spending represents the income of local firms that export goods and services to the rest of the world. Exports therefore constitute an addition or injection into the circular flow of income and spending in the domestic economy. An increase in exports will increase the income and spending in the domestic economy.

• Imports are spending that originates in the domestic economy. The spending by domestic firms that import goods and services represents the income of the other countries' exporters. Imports therefore constitute a leakage or withdrawal from the circular flow of income and spending in the domestic economy.

Financial sector in the circular flow of income and spending

• The main function of the financial sector is to act as a funnel through which saving can be channeled back into the circular flow in the form of investment spending.

• Households and firms who do not spend all their income during a particular period save some of their income. For households the decision to save also implies a decision not to spend on consumption. Saving therefore represent a leakage or withdrawal from the circular flow of income and spending. Saving from households and firms is channeled, for example in the form of saving deposits, to financial institutions.

• Financial institutions in return channel these funds to firms who wish to expand their production capacity by purchasing capital goods such as machinery and equipment. This is known as investment and represents an addition or injection into the circular flow of income and spending.

The major elements of the circular flow of income and spending

• The basic flow is between households and firms. Households provide factors of production to firms who use these factors of production to produces goods and services. In return for the factors of production, households receive income from the firms. Households then spend some of this income on goods and services. This is consumption spending in the economy, denoted by C, and is an injection in the circular flow of spending. The part they do not spend is saved, denoted by S, and channeled to the financial sector and is part of the leakages from the circular flow. From the financial sector these saving is channeled to firms in the form of investment and is part of injections into the circular flow of income and spending.

• The government buys goods and services from firms. This government spending is denoted by the symbol G and is an injection into the circular flow of income and spending. To finance their expenditure they impose taxes, T, on households and firms. This then represents a leakage from the income and spending flow. Firms sell goods and services to the rest of the world and it is called exports and form part of the injection in the circular flow. Firms and households also buy goods and services from the rest of the world which represent the imports, Z, and are part of the leakages from the circular flow.

Quiz• Indicate whether the following statement is true or false.

• The three major flows in the economy as a whole are total production, total income and total spending.– ? True – ? False

• The two basic sets of participants in any economy are household and firms.– ? True – ? False

• What is the difference between production and income? (4)

• What is the difference between production and income (on the one hand) and spending (on the other hand)? (4)

• Name the three major flows in the economy as a whole and explain how they are related. (6)

Circular flows• Indicate whether the following statement is true or false.

• Members of households are called consumers.– ? True – ? False

• Consumers are rational, in other words they will always try to maximise their satisfaction given the means at their disposal.– ? True – ? False

• Households are responsible for the spending on consumer goods.– ? True – ? False

• Capital goods are purchased by firms.– ? True – ? False

• Firms are mainly involved in consumption while households are mainly involved in production.– ? True – ? False

• There are two sets of markets in the economy, goods markets (eg the market for tomatoes) and factor markets, (eg the labour market).– ? True – ? False

• Firms purchase in the factor markets and sell in the goods markets.– ? True – ? False

• Households sell in the factor markets and purchase in the goods markets.– ? True – ? False

• What are the two basic sets of markets in the economy? (4)

• Explain the goods and services circular flow by means of a figure. (4)

• Explain the income and spending circular flow by means of a figure. (4)

• Indicate whether the following statement is true or false.• Show questions one by one• <=1 / 3=>

• The major flows associated with the government are government spending, taxes and transfer payments.– ? True– ? False

• Taxes are a leakage (or withdrawal) from the circular flow or income and spending.– ? True– ? False

• Government spending is a an injection into the circular flow of income.– ? True– ? False

• Illustrate the linkages between government, households and firms using the circular flow model of income and spending. (6)

• List (i) three important injections into the basic circular flow of income and spending(ii) three important leakages or withdrawals from this flow (6)

• Indicate whether the following statement is true or false.

• An open economy is an economy in which there is no government intervention.– ? True – ? False

• The foreign sector is linked to the domestic flow of income and spending through imports and exports.– ? True – ? False

• Imports are a leakage (or withdrawal) from the circular flow of income and spending.

– ? True – ? False

• Exports are an injection into the circular flow of income.– ? True – ? False

• Illustrate the linkages between the foreign sector and government, households and firms using the circular flow model of income and spending. (8)

• Illustrate how the financial sector fits into the circular flow of income and spending.(10)

• Indicate whether the following statement is true or false.

• Investment is a leakage (or withdrawal) from the circular flow of income and spending.– ? True– ? False

• Saving is an injection into the circular flow of income.– ? True– ? False